Undercut Lows Can Be Painful

Senior Research Associate Andrew Adams, CFA, CMT, weighs in on where markets stand after Thursday’s drawback.

"Mama said there'll be days like this There'll be days like this, mama said (Mama said, mama said)." – The Shirelles, 1961

Mama may have said there'd be days like this, but we don't recall her saying anything about there being weeks like this! Yesterday saw another ugly end to an ugly session, though despite the carnage, we still believe this to be part of the bottoming process. Recall what Jeff Saut said Tuesday afternoon on CNBC:

"What should happen here is a 'selling climax low' today followed by a throwback rally that fails leading to a retest of the recent intraday 'lows.' The perfect chart pattern would be for a marginal 'undercut low' downside test of this early week's trading lows, which would turn EVERYBODY bearish looking for another huge leg to the downside, yet we would BUY it believing the worst has been seen in a continuing secular bull market."

So, to recap: we got the selling climax Tuesday morning, we got the failed throwback rally on Wednesday, and we got the retest of the early week's trading lows yesterday that ended up producing the marginal undercut low described as the "perfect chart pattern." Eerily similar trading action was seen twice in a six-month span back in 2015/2016 (albeit at a much slower pace) to illustrate that this is often how markets bottom.

Moreover, by many measures, yesterday's selling was not as bad as we have seen recently, despite the S&P 500 falling to its lowest point during this pullback:

The VIX topped out at 36 yesterday compared to 50 on Monday.

Fewer stocks in the S&P 500 closed at new 52-week lows yesterday than did so on Monday.

Equity Put/Call Ratio not as stretched in favor of puts as on February 2.

111 NYSE common stocks closed at new lows compared to 175 on Monday.

Advancing issues vs. declining issues on the NYSE and NASDAQ was not as weak yesterday as on Monday.

Volume in declining stocks as a percentage of total volume was less on the NYSE yesterday.

What this means is that while a lower low was made in the S&P 500 yesterday (a lower intraday low was not made in the Dow, by the way), the selling was not as extreme as it was earlier in the week. We believe this is a sign that selling pressure is becoming exhausted and the pullback is nearing its end. Thursday's session fell just short of registering the third 90% Down Day in the last week, according to Lowry's, as down volume was 89% of total volume instead of the requisite 90%. 90% Down Days are usually pretty good indications of selling extremes, so the fact that we've almost had three in one week is worth noting.

One potential red flag, however, is that the Dow Jones Industrial Average did close below its December closing low of 24,410 to give us violation of the "December Low Indicator." The December Low Indicator comes into play whenever the Dow closes below its lowest closing low from December during the first quarter of the year. Our inboxes were slammed yesterday after the close with questions asking what this meant going forward, and so we did some digging into recent history to see what occurred after past violations. The last time it happened was only two years ago, back in 2016, though the situation was very different considering January 2016 began almost right where the December 2015 low sat, and the Dow ended up closing beneath it on the third trading day of the year. That, of course, culminated in the January/February correction that ended on February 11 and saw the Dow ultimately fall about 14% from its previous trading high of early November 2015. After that, though, the market went almost straight up to finish the year comfortably higher. Overall, the December Low Indicator has a rather mixed history going back to 2000. It is actually not uncommon at all to get a violation, with 12 occurrences since 2000, and the forward returns have been surprisingly encouraging. From the point of the December low being broken, the Dow was up after three months 8 out of 12 times, up after six months 7 out of 12 times, and up after 12 months 9 out of 12 times. So, while it does bear watching, we don't think the indicator, by itself, is enough to be overly concerned about, especially with stocks already near downside extremes.

Finally, it is important to remember that what we're going through now is not that abnormal. What was abnormal was the straight up, relentless rally of the last two years with absolutely no downside at all. The S&P 500 has experienced a 10% correction about every 25 months, on average, going back to 1932, and it had been almost right at 24 months since the last time the index had one. Only about 15% of NYSE stocks ended yesterday above their 50-day moving averages, too, which is consistent with levels that have historically marked bottoms. And this morning we awoke to a pleasant surprise with the futures actually marginally positive as of 6:45 am. That is encouraging, though our mantra of "never on a Friday" will be put to the test if the market does try to turn around today. Should we fall once again, 2565 and 2540 appear to be the important levels to watch; amazingly, the major averages remain above their 200-day moving averages despite the recent correction, a sign of just how extended they were. The 200-DMA sits right around 2540 on the S&P 500.

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